Mindspace REIT – Is it a Stud or Dud?

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Every Building is a prototype, no two are alike.

Helmut Jahn

This article has been written by Khubaib Abdullah for FinMedium Research Desk.

These words of the great architect Helmut Jahn hold not just for buildings, but also for a collection of building managed professionally, distributing the proceeds to the investors.

A REIT in other words!

This article is in many ways the second and final installment of the articles on REIT business in India. There are only two listed entities that India can boast of as of today.

Hopefully, this number will change for the better. To read the first part, which I would highly encourage if you’re new to REITs or wish to read about the other listed Indian REIT, head on to Embassy REIT.

To read about the IPO of the Mindspace REIT go here.

Click here to access the Excel Model used for valuing the Mindspace REIT.

Introduction to REITs

A Real Estate Investment Trust (REIT) is an entity that receives money from financing and/or building real estate properties. 

And for common terms and analysis framework head on here

Mindspace REIT is an equity-based REIT, focussed on acquiring land, developing it, and then renting out space. This is mostly office space in tier 1 cities of India, such as Mumbai and Hyderabad, and other upcoming metropolitans such as Pune and Airoli.

This is in contrast to the Embassy REIT that has its base in Bangalore majorly. 

The sponsor of the Mindspace REIT is the K Raheja group which itself boasts of 4 decades of real estate business experience in India with interests in Malls, Hospitality, Office, retail and residential properties.

Mindspace REIT owns a quality office portfolio across four key office markets of India. With a Total Leasable Area of c. 29.5 msf, it is one of India’s largest Grade-A office portfolios. Mindspace REIT comprises of five integrated business parks and five quality independent offices.

There are majorly five ways for a REIT to expand its business. They are as follows:

  • Rent escalation from existing clients using renewals and market to market (M2M)
  • Acquiring ready-made properties in new or existing markets for the purpose of renting out.
  • Acquiring land pools and developing them for renting out purposes.
  • Handing out loans to other REITs and collecting interest income.
  • Providing CAM services.

Now Mindspace REIT is only in the business of renting out spaces, thus making it an equity REIT. REITs that get income from extending loans to other REITs are rightfully called Mortgage REITs.

It is in the case of Equity REITs that one must also analyze the asset and client base of the REIT.

Asset Portfolio of Mindspace REIT

asset-portfolio-mindspace-reit
Asset base of Mindspace REIT

Total Leasable area is the sum of Completed Area, Under Construction Area and Future Development Area.

The figures for Mindspace REIT are a Total Leasable Area of  29.5 MSF out of which 23.9 MSF completed, 2.0 MSF under construction, and 3.6 MSF under future development plan as of September 30, 2020.

The client base for Mindspace REIT seems robust with INR 54 average rent psf, 89% committed occupancy, and 5.6 Weighted average Lease Expiry, Mindspace REIT offers tough competition to Embassy REIT in terms of its operations, although Embassy boasts of a much larger leasable area, better occupancy and longer WALE, it also happens to operate in the traditionally risky business of Hotel hospitality, thus pushing its Net Debt to Market Value higher than Mindspace REIT. 

market-value-mindspace-reit
Assets breakup based on geography
city-wise-footprint-mindspace-reit
City Wise Footprint

Mindspace REIT, in spite of its minor shortcomings, operates in the traditionally safer Office space renting business only, which reflects in their lower Debt to Market Value.

Secondly, Midspace REIT operates in a more tumultuous, but well-diversified portfolio spread across Mumbai, Chennai, Pune, and Hyderabad, while 64% of the Embassy REIT business is concentrated in Bangalore.

A summary of metrics for the Mindspace REIT metrics is given below.

key-metrics-mindspace-reit

A breakdown of the client base is shown below. Similar to the other REIT, Mindspace REIT also has IT as the major client, however, it is heavier on the Financial Services side.

This works in favour of the Mindspace REIT as the financial firm and IT service industries are majorly the ones that have come out unscathed from the COVID 19 pandemic.

We shall look at the effect of COVID 19 on the REIT ahead. Close to 9.1% of the portfolio is industries that are badly hit by COVID 19 viz. Healthcare and others.

clients-mindspace-reit
Industry breakdown of the clients
rentals-contribution-mindspace-reit
Client Base of Mindspace REIT

Close to 41% of the rent revenues are from the top 10 clients in Mindspace REIT, a number remarkably similar to the Embassy REIT (which was at 42%).

The clients are all major MNCs, thus ensuring a constant and uninterrupted supply of rent.

There however is a point worth considering which was raised in the most recent investor calls. Close to 1.8 msf was recognised as an area eligible for potential renewal and hence mark to market opportunity.

However, out of this 1.8 msf, only 0.6 msf has been re leased.

The reason as cited by Mindsace REIT management is that a lot of their clients have chosen to go ahead and buy their own office space, such as Deloitte and Capgemini. 

In light of this, it remains to be seen how well the management is able to acquire new clients to fill in these vacant spaces and retain them. The past performance of the Mindpsace REIT is shown below.

leasing-spread-mindspace-reit

Ignore the average re-leasing spread. It is the trend, not the average that matters. The Mindspace REIT management has observed a very high risk for the portfolio in 2018 when the spread for re-lease was 37.7%.

This is important to note. Fast forward to 2021, when the re-lease spread is 33.1%. The spread is higher when there is no pandemic risk (in 2018), while it is lower while the pandemic rages on.

The landlord offers low spread so to attract clients and higher spread when it feels the client may not be able to keep up with the rent payment. Mindscape REIT has kept its lease renewal at 37.7% before, keeping it lower than this is a pandemic stricken environment suggests desperation for clients on the Mindspace REIT side.

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The ability of the management to get new clients is thus put under some doubt. This is a point which needs to be kept an eye for in the future.

Operational Analysis of Mindspace REIT

Industry Sector of Occupiers

Most of the topmost clients come from the financial services and IT industry. Most of them are large MNCs. The sector of the occupiers also exposes the REIT to the risks of that sector. Although the rents are counted as operating expenses and thus are paid even when the client goes bankrupt. 

Occupancy Rate and WALE

The occupancy rate ranges from as low as 70% in some parks to 100% in most. The average occupancy is lower than Embassy REIT at 87% for Mindspace REIT. The WALE is also on the lower side. It stands at 5.6 years. Some parks’ WALE is as low as 2.7 years and 1.8 years, which is a serious cause of concern. 

Longer the WALE, more guaranteed are the dividends for the unitholders.

Escalations

The rent escalations spreads are high at 33%. This is in sharp contrast to Embassy REIT whose escalation rate is at 10-15%. Lower rent escalation allows for more rent growth opportunities.

This also attracts more tenants. Higher rent escalation rates not just equates to fewer tenants to choose from, but also signifies the fact that the landlord considers the tenants to default on their payments. 

What we see here is a point of contention between two large companies, both see the future differently.

It shall be interesting to see whose view turns out to be correct. However, it needs to be kept in mind that Embassy REIT has much more room to grow, than Mindspace REIT as far as the escalation rates are considered.

Development Timeline

Mindspace REIT has brought more area under development. The COVID 19 effect has mostly subsided as 75% of the workforce is back on the site. About 5.6 msf of the area is under development. Midspace REIT hopes 1.8 msf of it to be completed by 2022.

development-timeline-mindspace-reit
Development Pipeline

Risks and Emerging trends for Mindspace REIT

The Indian real estate industry looked pretty rosy, as 2019 witnessed large inflows of foreign cash inflows, clearly a sign of the reversal in the long continuing era of unsold inventory and no buyers.

Then 2020 happens.

This results in lack of supply for office spaces due to a large number of companies preferring to keep their employees’ health in mind and shifting to a work from home model. Apart from this very obvious reason, the following is witnessed (as reported here):

  • Rental concessions and revisits. Due to a lack of revenues for a lot of companies due to complete lockdown, the amount of money they can spend on rent has fallen. This means that a lot of them will face great strain in meeting their rent agreements. While Mindspace REIT employs the strategy of securing security deposits with 6 months of rent in advance, tenants asking for rent-free periods simply to continue occupancy may not be out of the horizon. This situation socially gets exacerbated in the case of Mindspace REIT as they happen to have a portfolio of marquee clients, where the tenants really hold the strings, not the landlord. We also saw how the renewal spreads have been kept lower to attract clients.
  • De Densification Trends.  The densification trends of the 1980s seem to be on a reversal, thanks to the social distancing norms that have been made mandatory. The following chart shows the mark to the market opportunity that the Mindspace REIT has. All of this can be achieved, along with extra space being released.
  • COVID 19 Preparedness. Most of the companies would require appropriate sanitation and safety norms in place for their employees. Mindspace REIT is well-positioned to offer that, which is certified by the British Council’s Safety Award and several other measures the REIT has taken.
  • Shared Offices and Coworking Spaces. There has been a clear rise in the shared co-working spaces over the past years. Office spaces, unlike the traditional long term triple net lease agreements, have been forced to adapt and function like the riskier, but more flexible Hotel and Hospitality model, where the landlord assigns the space for a startup or such, similar to how a hotel allots rooms to guests. While this has not really caught up with the larger firms, the prevalence of such trends in the future may shift the ball from the landlord to the tenants. REITs will lose the safety feature/tag they have always enjoyed.
  • The shift from triple net leases to Full Services Leases. The traditional triple service leases may be hit as the supply side bulges, and tenants get more options to choose from. Lower renewal spreads, lesser lease durations, lowers CAM costs, and higher rent-free periods may be common in the times to come.

To know more about the real estate related terms such as Triple Net Leases and Full Service Leases, head on to here.

Keeping all this and much more in mind, as Financial Express reports here, total new leasing activities is estimated to be down by over 50% in FY 21.

Likewise, a rent compression of 10-25% is expected for 2-3 quarters in mid-to-large size areas depending upon locations.

Mindspace REIT seems to be very resilient in this regard, with occupancy levels close to 90%,  0.6 msf of area re-leased, addition of several new marquee tenants, low expected expires of around 8.2%, 17% mark to market opportunity and 5.6 years of Weighted Average Lease Expiry (WALE), seems to be on very solid ground.

To know more about the real estate related terms such as WALE, head on to here.

Mindspace REIT Structure

Embassy REIT has a partial UPREIT structure. In a UPREIT structure the REIT does not own most of the properties itself, rather it is in an operating partnership with some other company called the Operating Partnership (OP).

As we can see below in the chart, the UPREIT is the sole partner of the OP. The OP is responsible for managing the properties, collecting rents, operating them if need be and then passing on the profits in the form of dividends to the UPREIT (Embassy REIT in this case), which then passes on the dividends to unitholders like us.

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The benefit of the OP is twofold, one, it allows to jump through legal hoops and second, it creates a new form of currency for the UPREIT which already is stripped of cash: the OP shares.

These OP shares can also be used to acquire properties without getting into risky financing.

This REIT structure is a more modern approach that was the sole reason behind the REIT boom in the west. Adoption of such a model by the Mindspace REIT further strengthens its position as a REIT in Asia.

business-parks-structure-mindspace-reit
Mindspace REIT structure

Unlike the REITs in the west, the REIT industry is in a rather nascent stage in India. REITs here do not act as “Mutual Funds for Real Estate”, like they should. Though the structure is the same, the purpose isn’t.

REIT sponsors such as KRC in Mindspace REIT’s case, use the IPO cash to fund their construction projects.

The bargain is simple, you get the funds to construct with the caveat that you have to share the profits.

In most cases, the sponsor is one of the biggest shareholders, along with some marquee global investor such as Balckstone, which not just gets the dividends without the hassle of construction, but also an entry into the rising Indian markets. 

The REIT ends up owning only properties constructed by the sponsor. The OP structure allows to fund all of these acquisitions with OP shares, without the risky financing. It’s a win win for all.

Except that the arrangement seems to be too rigid, with little skin in the game. The alliance is new and it remains to be seen how it unfolds in the coming years.

Financial Analysis of Mindspace REIT

Mindspace REIT’s operating and maintenance expenses primarily consist of repair and maintenance (of buildings, common areas, machinery, and others), power and fuel expenses, property management fees and expenses related to  housekeeping and security services.

For its housekeeping and CAM services, Mindspace REIT has acquired Facility Management Business in October of 2020. It shall service not just Mindspace REIT assets and also outside the business.

There are a few hitches that one faces when analysing SPV such as Embassy REIT. One of them is that there is no standardised reporting when it comes to reporting their financials. 

Why can they not use the same IND AS guidelines as used by other companies?

The reason lies in the very structure of REITs. Most of the value of a REIT arises from the properties that it holds.

While standard accounting calls for a gross book value of that property, depreciated by the chosen method over its useful life to arrive at its Net Book Value, this can’t be used for REITs such as Embassy REIT.

This is because these properties act more like investments that can appreciate in value rather than always depreciate no matter what, the way standard accounting calls for. 

You may arrive at some Net Book Value of the REIT using the standard way. But the number you arrive at will be far off from the actual market value of the assets. You may end up undervaluing a REIT that may actually be healthy!

Another important distinction is regarding earnings. What we call earnings for other companies, does not really make a lot of sense for the REITs, such as Embassy REIT.

What replaces earnings here is FFO or Funds From Operations. This the cash that the REIT generates from the existing asset base, less the effects of financing, acquisitions, or other such overheads and non-business operations.

For more such information on REIT check this out.

Operating Metrics

NOI – Net Operating Income

Net operating income, or NOI, is similar to an operating company’s gross profit margin.

NOI equals the sum of rental revenues from properties plus any tenant reimbursement revenue, less all property operating expenses, including fees paid to any third-party property managers, taxes, and insurance.

NOI measures the property-level profit on a stand-alone basis, excluding the REIT’s corporate overhead or the effects of financing. 

net-income-mindspace-reit
Net Operating Income

The NOI of Mindspace REIT stands at 1983, which is 72.4% of the revenue generated. This number is very high as generally is the case with REITs. All REITs calculate their NOI differently. Thus it only makes sense to carry out your own NOI calculation. To understand how this calculation was done, see this. 

Mindspace REIT deals only in office property, thus it continues to be a rather safe bet.

Same-Store Earnings

Growth in a REIT’s same-store NOI measures a REIT management team’s ability to grow earnings internally, or “organically”— without buying or building new assets.

Mindspace REIT’s same-store earning stands at 89% indicating robust ability to generate business organically, without acquiring/building new properties.

However, it must be noted that Mindspace REIT has 1.8 msf of the area under construction. Thus Mindspace REIT has not just strong internal growth, but also a potential for robust external growth as well.

Profitability Metrics

FFO and CAD

To know what these terms mean, head on to here

Like C-corporations, REITs report net income and EPS calculated in accordance with INDAS. However, REITs must depreciate the cost of their properties (excluding the amount allocated to the cost of land) over the useful life of an asset.

Yet well-located and -maintained buildings tend to appreciate in value over time.

To address the discrepancy between INDAS rules and current market values for real estate, the REIT community adopted FFO as a supplemental measure of earnings per share.

FFO and two additional supplemental performance metrics—adjusted FFO (AFFO) and cash (or funds) available for distribution (CAD or FAD).

cash-available-mindspace-reit
Cash Available for Distribution

Mindspace REIT happens to generate INR 2782 million in first quarter FY 2021. Since the REIT was listed on the exchange recently, it has not declared its dividends.

The management expects to distribute 90% of their cash as dividends. We can safely assume that the amount distributed would be close to INR 2782 million.

Mindspace REIT can generate a dividend of INR 4.7 per unit per quarter as far as my calculations go. The REIT has not yet declared any dividend as it was listed on the exchange very recently.

This will be the quarterly dividend. The actual figures may be different due to one or more of the reasons such as management decides to distribute not the whole but only part of the amount, decides to declare a special dividend for the preferred shareholders etc.

The IPO DRHP of Mindspace REIT also suggests a sum that seems to be in line with the above calculations. The management claims to generate INR 11478 million (5739 * 2) in 2021.

cash-projections-mindspace-reit
Net Distributable Cash Projections from the IPO DRHP

This number is remarkably close to the above calculated sum of INR 11128 million (278 * 4).

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It for this reason I shall be using this figure (INR 278 million per quarter) in the rest of the analysis.

Balance Sheet Metrics and Analysis

Leverage results in impressive FFO per share growth; however, it also adds significant risk and, historically, when combined with an economic slowdown, has been the root cause of many private real estate company bankruptcies. Thus it is important that this metric is kept under control at Mindspace REIT.

Debt-to–Total Market Capitalization Ratio

debt-to-marketcap-mindspace-reit
Debt to Market Cap Ratio

The debt ratio of Mindspace REIT stands at 24%, which is pretty high as compared to Embassy REIT that had 17% as its number. Mindspace REIT has very recently issued debentures which were of the AAA rated category.

The proceeds of INR 5000 million at 6.5% are to be used for services for the long term as per the Half Yearly report, the same goes for IPO proceeds. Close to 90% of the IPO proceeds amount has been used to service the debt of several REIT owned SPVs.

No other information is given in the Half yearly report.

The above ratio indicates the part of the Mindspace REIT that has been funded by debt. While there have been REITs that were funded 90% by debt, sadly they could not exist for very long.

Real estate cycles can be brutal, slow, and very long. Mindspace REIT is 24% funded by debt. 

One metric which the management has touted greatly is the cost of debt that has fallen from 9.22% to 8.06%. This has been mostly because of the debentures issued by the REIT. These are Non Convertible Debentures issued at 6.8% and raised close to 5000 million INR.

They are G Sec linked though and give the 6.8% only if the G Sec’s last traded price is 25% more than the proceeds on the last date of interest payment of NCD. Otherwise, it is 0. 

Talk about free money…

Weighted Average Cost of Debt

Debt to Book Value

This is a measure of how much of the debt taken by the company can be covered by the book value of assets.  This number must be as low as possible and sadly is quite high for Mindspace REIT.

Debt to Gross Book Value

Debt to NOI

Debt to NOI

This is a measure of how much time it will take for the REIT to pay off its debt. For Mindspace REIT, it will take around 7.6 years to pay off its debt if the current levels of NOI continue for the next 7.6 years and no more debt is taken.

This is surely a very high number. The REIT is very over leveraged it seems. The same number stood at 3 years for Embassy REIT.

For more of such valuation techniques head on here.

Valuation Metrics

Price to Earnings

As was discussed at the beginning of this chapter, REITs trade-off expected FFO per share estimates rather than EPS.

To know why FFO is sued instead of earnings, head on to here.

Accordingly, REIT earnings multiples are expressed as FFO multiples, calculated simply as the current stock price divided by current FFO per share estimates.

A lower FFO multiple may indicate a REIT is trading at a bargain price.

Price to FFO

Mindspace REIT however doesn’t seem to be trading at bargain price though. Its contemporary Embassy REIT trades at 9.7 close to half the PE.

Dividend Yields

There are three General Rules about Dividend Safety

  • REITs that own property types with short-term lease revenues carry more risk of cutting their dividends than those with longer-term leases.
  • Dividends tend to be more at-risk in companies whose management teams incur too much leverage. A debt-to–gross asset value of 50 per cent generally should be the absolute maximum amount of leverage. 
  • REITs with dividend yields that materially exceed the industry’s average tend to be companies with significantly more corporate risk and less secure dividends. 
Current Yield (assumed)

The dividend yield of Mindspace REIT is close to 5.7%, which is not much better than the 10 year G Sec yield. This number however is based on an assumption and Mindspace REIT has not declared a dividend at the time of this writing. This is just an estimate. In any case, they’ll have to borrow to pay a higher dividend, which itself is a shabby thing to do.

Dividend Payout Ratio

Dividend Payout Ratio

FFO Payout Ratio indicates the relative safety of the dividend. If the number is below 100%, the dividends are relatively safe. For Mindspace REIT it is close to 95% which is good enough. The dividends at the Embassy REIT seem to be safer as the same metric holds at 69% for it.

Net Asset Value

Net asset Value is an important metric for Mindspace REIT.

Thus unlike the usual companies where land or real estate is more of an asset related to the operational side of the business, for a REIT, it is more on the investment side.

It is always better if the value of the property increases as time goes on. Thus looking at only the book value of the assets of  Mindspace REIT would be very partial.

For more information on this check this out.

NAV of the assets

The Net Book Value of assets per unit for Mindspace REIT stands at 275.56, which is a rather useless measure in my opinion. The other one, Net Fair Value of Assets per unit is 338. Though this is better than the other measure, it also holds very little significance. The CMP of the Mindspace REIT stands at 327.5. 

The best measure is the Net Market Value of the Assets per unit price and that number stands at INR 404.85. Note that this number comes from the Half Yearly reports itself conducted by a third party. This number is susceptible to market winds of change.

Other Important Data for Mindspace REIT

nav-movement-mindspace-reit

This article has been written by Khubaib Abdullah for FinMedium Research Desk.

Sources:

Mindspace REIT Half-yearly reports, Investor presentations, Call Transcripts and IPO DRHP.

Financial Express article

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